19 August 2009

Future Options - A Bit Different

With Liberty trading Group running all over the shop promoting the writing of commodity futures options, I thought it would be a good time to highlight some of the differences between futures options and stock options.

This first post is on pricing.

Anyone who looks at payoff diagrams will notice a slight difference in how futures options are priced. The most obvious diagram to look at is a straight out ATM long call and the corresponding long put.

Supposing you have two instruments with all things being identical, i.e. all inputs into the model are the same, but one is a futures option and the other a stock option. You will notice that stock option calls are more expensive than the futures option call. Likewise, the stock option puts will be cheaper than the futures option puts.

Also, if exactly at the money, the futures options call and put prices will be virtually identical.

Furthermore, again if exactly at the money, you will notice that stock option calls will have a delta of greater than 0.5, with the negative delta of puts less than 0.5 (the absolute values of both should add up to 1), whereas the futures option will be very much closer to, if not exactly 0.5 each.

The reason for this is the cost of carry priced into the options. Stock options make the assumption that someone is holding stock and is entitled to be paid carrying costs in lieu of risk free interest, whereas a futures option is an option on another derivative contract. This means that carrying costs priced into futures options are negligible.

There are a few other differences which I'll be going over ion the next few days - stay tuned